Investment Decision Flashcards
What do capital investment projects involve?
Outlay of large sums of money in expectation of benefits that take several years to accrue
What are relevant cash flows
A future incremental cash flow caused by a decision
What is an opportunity cost?
Cost incurred from diverting existing resources from their best use
What are non-cash flows?
Depreciation and overheads not directly attributable to the project. Not a relevant cost
Materials used in projects (relevance in a replacement)
The replacement cost of the material is relevant if there’s a replacement. Not the historic cost
Materials used in projects (relevant cost)
Relevant is zero, unless there’s an opportunity cost from lost revenue if material sold as scrap
When are historical costs of materials only treated as relevant?
If no indication of scrap values or replacement costs are in the question
If labour used in a project is idle?
The relevant cost of using that labour is zero
If labour cost is at full capacity?
The relevant cost is wages paid + contribution lost on work they have to stop doing
Finance costs and relevance?
Should not be considered as a cash flow as they are included when discounting the project
Why are sunk and committed costs not included?
As they will be incurred no matter what
What is a payback period?
A measure of how long it takes for cash flows affected by decision to invest to repay cost of original investment
Issue with a project with a long payback period?
It is uncertain because it relies on cash flows in distant future
When will a company reject a project in payback period?
if a payback period is above company’s target payback period
When is payback useful?
if company has cash flow problems as it focuses on shorter-term investments
Problems with payback?
Ignores cash flow after end of payback period
Ignores TVM
May lead to excessive investment in short-term projects
Other names for ROCE?
Called ARR and ROI
Basis for ROCE?
Compares the profit from an investment project to the amount invested in the project
When company accepts project under ROCE?
If ROCE is above company’s target
Advantages of ROCE
Quick and simple
Easy comparison
Disadvantages of ROCE
Based on accounting profits
Takes no account on size of investment as relative
Ignores TVM
Why is DCF important?
Many projects involve investing money now and receiving returns in many different time periods in the future
What is a present value?
Cash equivalent of money received/paid in the future
What is the discount factor?
Reflects investor’s required return and timing of future cash flow
